Examples of Financial Ratio Analysis for Companies

Financial ratios are an indicator of health for any business. They may seem esoteric, but to lenders and investors they tell the true story of a company's financial strength and ability to weather an economic storm. There are simple measurements such as debt to worth and complex indicators such as receivables turnover days or payables days. The more revenue a company generates, the more relevant the sophisticated ratios become. In their simplest form, the ratio is used to balance one asset against another or compare assets and liabilities. They are mathematical expressions such as: $4,000 in the equity account compared to $2,000 in total debt yields a 2:1 debt-to-worth ratio. Evaluation of specific ratios are difficult to define because each industry has its own characteristics.

Cash Flow Coverage

The most basic of the ratios is a measurement of cash flow or debt coverage. Lenders use this ratio to measure the company's ability to pay its debts. In the calculation, a company's net profit is calculated. This number is then assumed to be the amount available to repay debt. The standard most banks use for working capital is $1.20 in profit for every $1 in debt payments.

Current Ratio

Liquidity is a term used to describe a company's ability to raise cash in a short period, usually 30 days. The liquidity ratio measures the liquid assets of the company against the short-term debt in an effort to see if they are in balance or if the company is overloaded with short-term debt. High credit-card balances against low inventory and cash in the bank will be a red flag. Higher ratios are a positive indicator.

Quick Ratio

Another, more stringent measure, of a company's ability to meet its short-term obligations is the quick ratio. This is calculated using current assets and current liabilities. The difference is that inventory, included in the current ratio, is excluded from the quick ratio. Inventory is excluded because it may have to be sold at a loss or steep discount to realize cash in an emergency, therefore its value is not reliable.

Leverage

Leverage refers to the efficient use of assets to generate business. A strong company is able to borrow money to use as working capital and thus increase its business. The measurement of how much money a company has borrowed is the debt-to-assets ratio. Lenders and investors use this to gauge the likelihood that a company will be able to manage its debt load and the effectiveness of management in using the assets to build the business. One of the common leverage ratios divides total debt by total assets.

Application

Financial ratios are grouped by the type of information they provide the analyst. The broad groupings measure liquidity or the company's ability to generate cash. They measure profitability and company activity such as the business cycle to determine effective use of assets. They measure leverage to test the company's ability to grow. Finally, they measure results used by shareholders such as earnings per share, book value and the price-earnings ratio.

About the Author

After attending Pasadena City College as a business major, Ron Sardisco spent 35 years studying small business and organizational behavior. More than 20 years as a banker, 10 years as a small business owner and five years as a business adviser fuel his passion for writing and mentoring others. An award-winning photographer, he was also a contributing columnist to the "Antelope Valley Press."

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